Illinois Agricultural Holding Co. v. Commissioner , 46 B.T.A. 1 ( 1942 )

ILLINOIS AGRICULTURAL HOLDING CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Illinois Agricultural Holding Co. v. Commissioner

Docket No. 104247.

United States Board of Tax Appeals

46 B.T.A. 1; 1942 BTA LEXIS 921;

January 2, 1942, Promulgated

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Where, pursuant to a contract with its principal stockholder, the petitioner made distributions out of its gross income to persons who had no business or contractual relations with and rendered no services to petitioner, held, that such distributions were not deductible business expenses, but distributions of profits.

C. C. Chapelle, Esq., for the petitioner.

Gerald W. Brooks, Esq., for the respondent.

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TYSON

This proceeding seeks redetermination of deficiencies of $876.88 and $953.86 in income tax for the calendar years 1936 and 1937, respectively.

Petitioner assigns error in the respondent's determination that petitioner's disbursements of $58,122.09 for 1936 and $69,667.27 for 1937, pursuant to certain contractual obligations, constituted a distribution of profits in the nature of dividend distributions rather than ordinary and necessary business expenses deductible from gross income, as claimed on petitioner's returns for those years.

Respondent affirmatively alleges that in his determination the above-mentioned amounts disallowed as deductions were included by him in the dividends paid credit allowed for each of those years, respectively. Respondent affirmatively alleges also, in the alternative, that, if the claimed deductions are allowed by the Board, then the amount thereof must be excluded from the dividends paid credit. No reply to such affirmative allegations has been filed by petitioner, who does not controvert respondent's alternative plea.

The proceeding has been submitted upon the pleadings, oral testimony, and a stipulation of facts embracing numerous exhibits. The stipulation is adopted as a part of our findings of fact and included herein by reference. We set forth herein only those facts deemed necessary for the purposes of this opinion.

FINDINGS OF FACT.

The petitioner maintains its principal office in Chicago and filed its Federal income tax returns for the years in question with the collector of internal revenue in Chicago, Illinois.

Petitioner was incorporated on December 12, 1928, under the laws of the State of Illinois and more particularly under "An Act in relation to corporations for pecuniary profit." The stated object in its "Statement of Incorporation" for which petitioner was formed was "to purchase, hold, sell, assign, transfer, or otherwise dispose of any stocks, bonds or other securities or evidences of indebtedness created or issued by any other corporation or * * * association * * * and while the owner thereof, to exercise all the rights, powers and privileges of ownership." Petitioner's authorized capital stock was issued as follows: 2,000 shares of first preferred stock, par value $25 per share, were sold at par for cash to various individuals and county farm bureaus in the State of Illinois; 600 shares of second preferred stock, par value $100, were sold at par for cash to the Illinois Agricultural Association, and 3,000 shares of common stock, no par value, were sold for cash to the Illinois Agricultural Association for $5 per share, making the total paid-in capital $125,000. Both classes of preferred stock provided for the payment of 7 percent cumulative dividends.

The Illinois Agricultural Association (hereinafter referred to as the Association) is a nonprofit corporation organized under the laws of Illinois to promote the welfare of agriculturists in that state and has about 63,000 members. It is a state-wide organization operating in Illinois, but is without governmental affiliation or funds and its main revenue is derived from membership dues. It promotes educational and marketing activities of farmers and fosters cooperative organizations.

In 1927 and 1928 the Association contemplated the organization of a life insurance company. Since it did not appear practical to organize a cooperative insurance company under the Illinois insurance laws, the Association desired to set up an old-line legal reserve life insurance company and through the method of its operations to make some provision whereby its earnings, which would lawfully accrue to its stockholders, might be distributed, in the nature of patronage dividends of a cooperative insurance company, to the Association's members having policies in the insurance company, in proportion to the amount of their insurance.

In 1928 the Country Life Insurance Co. (hereinafter referred to as the Insurance Co.) was incorporated with an authorized capital stocl of 4,000 shares par value of $25 per share. The amount of $125,000 received by petitioner from the sale of its own capital stock was invested in and paid for the $100,000 par value capital stock of the Insurance Co., giving the latter a capital of $100,000 and a surplus of $25,000. In 1935 the Insurance Co. declared a stock dividend increasing the par value of its outstanding capital stock to $200,000.

In consideration of the stated mutual obligations of the contracting parties, the petitioner and the Association entered into a written agreement dated January 11, 1929, and two written supplemental agreements dated December 9, 1932, and January 24, 1936, respectively. Under those agreements petitioner was to receive and segregate all cash dividends declared by the Insurance Co. on its stock owned by petitioner and to account for, distribute, and apportion such gross dividends in the manner and with priorities as follows:

First, to pay all corporate expenses including Federal and state taxes.

Second, to pay all annual cumulative dividends of 7 percent on its first and second preferred stock and 35 cents per share on its common stock, the total dividend requirement for those purposes being $8,750 annually.

Third, at its option, to set aside annually in a surplus fund 10 percent of gross dividends received, such surplus not to exceed $150,000 and to be used only for increasing the capital stock of the Insurance Co.

Fourth, to distribute the balance of the gross dividends:

(a) 25 percent thereof to members of the Association in good standing who are also policy holders in the Insurance Co., such distribution to be made on the basis of the proportion which the gross annual guaranteed premium, or premiums, of the member's policy, or policies, in the Insurance Co. bears to the total gross annual guaranteed premiums of all policies in the Insurance Co. held by members of the Association.

(b) 75 percent thereof to the charter policy holders of the Insurance Co., that is, to the holders of policies numbered from 1 to 8,000, inclusive, and upon the basis set forth in a nontransferable "Certificate of Participation", which petitioner agreed to issue to those charter policy holders. Such certificate referred to the agreement of January 11, 1929, and provided, inter alia, that the holder thereof "had a beneficial interest" in the 75 percent fund created from dividends received by petitioner as the sole owner of the stock of the Insurance Co.; that petitioner agreed to retain full ownership of the stock of the Insurance Co. while any one of the charter policies remained in force; and that the certificate holder, while his policy was in force, was entitled "to receive as his distributive share of said funds" the proportion which his gross annual premium bore to the aggregate of the gross guaranteed premiums of all policies numbered from 1 to 8,000, provided that, for each successive three-year period he should not receive distributions in excess of his gross guaranteed premiums for such period.

Under the above mentioned agreement of January 11, 1929, and supplements thereto, the Association, which the contract recited had sponsored and was interested in the Insurance Co., agreed to endorse and support the Insurance Co. in its campaigns for business and to promote the sale of its policies to members of the Association, but that the Association would not incur any expense to itself in so doing. It was further agreed that the Association should reserve and retain the right to define who was a member in good standing and, at its own expense, should furnish to petitioner a list of its members in good standing who were holders of policies issued by the Insurance Co. for the purpose of informing petitioner as to whom its distributions should be made.

From time to time the Insurance Co. declared dividends to its policy holders, who had the option of withdrawing such dividends in cash or applying them in payment of premiums due.

The operations of petitioner have been in accordance with its agreements with the Association and it has not engaged in any functions other than holding the stock of the Insurance Co., receiving the dividends declared thereon, and disbursing such receipts as provided in those agreements.

The petitioner received dividends of $72,000 in 1936 and $83,000 in 1937 on the stock of the Insurance Co. owned by it. Pursuant to a resolution adopted by its board of directors in each of those years, the petitioner paid the regular annual dividends, totaling $8,750, on its own outstanding capital stock, including all of its first and second preferred stock, as provided in its above mentioned agreement with the Association.

Pursuant to the agreement of January 11, 1929, and the two supplements thereto, and pursuant to a resolution adopted by its board of directors in each year, the petitioner distributed the amount of $58,122.09 during 1936 and $69,667.27 during 1937, such distributions being made in the proportion of 75 percent to the individual holders of participation certificates who were also charter policyholders in the Insurance Co. and 25 percent to the other individual policyholders in the Insurance Co. who were also members of the Association. The petitioner maintained corporate records which disclosed the name and address of each policyholder to whom payment was made, the policy number, the date on which payment was made, the mode of payment and amount of premium, the policy dividend, and the check number. On petitioner's books of account the above mentioned distributions for 1936 were referred to as "Dividends Paid, Special Distributions", and those for 1937 were referred to as "Special Distributions" and the amounts thereof were charged against surplus.

Pursuant to a contract obligation the petitioner made distributions of $58,122.09 during 1936 and $69,667.27 during 1937 to two classes of holders of insurance policies issued by the Insurance Co. Such distributions were made out of taxable income derived by petitioner from its principal business of owning the capital stock of the Insurance Co. and constituted distributions of profits and not ordinary and necessary expenses of carrying on petitioner's business.

OPINION.

TYSON: Petitioner herein raises no issue and makes no contention as to the propriety of including in its gross income, subject to the credit provided for in section 26(b) of the Revenue Act of 1936, ^{*931 23(a) of the Revenue Act of 1936, *6 operating expenses and declared and paid regular annual dividends, amounting to $8,750 for each of the taxable years, to the holders of its own outstanding capital stock. Also, out of such gross income or earnings, petitioner, under its contract with the Association, made the distributions here in question to persons who had no contractual or business relations with and rendered no services to petitioner. While the petitioner's distributees purchased insurance from and paid premiums to the Insurance Co., which in turn paid dividends to petitioner, it can not be said that such distributees were doing business with or rendering services to petitioner in the production of income realized by it. The petitioner's income was produced through dividends declared by the Insurance Co. out of the latter's net profits realized from its business operations.}

In each of the taxable years the petitioner was in receipt of taxable income out of which it made the distributions in question claimed as deductions from gross income. The extent to which deductions from gross income are allowable depends upon legislative grace and the taxpayer seeking a deduction must be able to point to and show that the comes within the terms of an applicable statute. . The petitioner points to section 23(a), supra, which deals with ordinary and necessary business expenses, but, in our opinion, fails to bring itself within the terms of that section because the distributions in question were not necessary charges upon the continued operation of petitioner's business nor an outlay as a consideration for producing its income, and thus were not ordinary and necessary business expenses of petitioner.

The facts in the instant case distinguish it from , and , solely relied upon by petitioner. In those two cases and also in ; (the latter two cases not cited by petitioner), wherein amounts paid by the taxpayers under contractual obligations were allowed as deductible business expenses, the payments were made to the party, or parties, to the contracts who had business relations with the taxpayer, through which relations (a) the business of the taxpayer was continued or (b) income was produced for the taxpayer, so that in either event the payments made under the contracts were directly connected with the production of the taxpayer's income and constituted a charge upon the operation of its business.

, is also distinguished from the instant case in that there the payments made under a contractual obligation and allowed as a business expense were necessary in order to avoid forfeiture of the taxpayer's franchise to carry on its business and thus constituted an ordinary and necessary charge upon the continued operation of that business.

The sole common stockholder of the petitioner was the Association, which, after the payment made by petitioner of all dividends due on its preferred stock in each taxable year, was entitled to receive all further distributions made out of petitioner's earnings in each such years, but by the Association's contract with petitioner the Association directed the petitioner to make such further distributions (those here in question) which would otherwise have been made to it, to the persons, and the distributions were made as so directed. We are of the opinion that the Association as sole owner of the common stock of petitioner thus constructively received the distributions from profits here in question, and hold that, since such distributions did not constitute ordinary and necessary expenses, they are not deductible in computing petitioner's net income. Cf. ; affirmed per curiam, .

Respondent's determination is sustained.

Decision will be entered for the respondent.

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Footnotes

• 1. SEC. 26. CREDITS OF CORPORATIONS.

  In the case of a corporation the following credits shall be allowed to the extent provided in the various sections imposing tax -

  * * *

  (b) DIVIDENDS RECEIVED. - 85 per centum of the amount received as dividends from a domestic corporation which is subject to taxation under this title. * * * ↩

• 2. SEC. 23. DEDUCTIONS FROM GROSS INCOME.

  In computing net income there shall be allowed as deductions:

  (a) EXPENSES. - All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business * * * ↩